The Basics




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Economics is concerned with marginal costs and benefits. Since our resources are scarce, we must decide the amount of pollution we are willing to live with. In order to have a pollution-free world, we would have to give up many other things. Money spent to clean up pollution would not be spent on education, roads, crime prevention, public health programs and so on.

The government usually provides for education, roads, etc. It does so because these are things our society considers very important but things that might not be provided for by private enterprise. Economists call these items market failures and have identified several types of market failures.





One type of market failure is a monopoly where there is a failure of competition. One recent example is Microsoft. Microsoft's rivals in the computer software industry showed that Microsoft had attempted to develop its dominant position in operating systems software (such as Windows) to gain a dishonest advantage and so create a monopoly in operating systems. Microsoft also created a monopoly in the sales of its applications software (like Microsoft Word).







A public good is a good that is provided in the same amount to all consumers if provided at all.

A pure public good is non-excludable and non-rival. Once provided it is impossible to prevent agents from consuming it but one agent’s consumption doesn’t reduce the amount available to other agents. Some examples are public TV, World Service Radio, air, etc.

A free-for-all public good is non-excludable and rival. It is impossible to prevent agents from using it and one agent’s consumption does reduce the amount available to other agents. Some examples are roads, fish, public beaches, etc.

Since public goods are non-excludable, they represent a type of market failure.




                  WatchThe Tragedy of the Commons (3:19)


In 1832, William Forster Lloyd observed the devastation of common pastures and the puny and stunted draft animals that grazed on them.

Immigrants to New England in the 17th century formed villages in which they had privately owned homesteads and gardens, but they also set aside community-owned pastures, called commons, where all villagers' livestock could graze. Settlers had an incentive to avoid overusing their own private land, so it would remain productive in the future. However, the self-interested stewardship of private land did not extend to the commons. As a result, the commons were overgrazed and degenerated to the point that they were no longer able to support villagers' livestock.

In 1968, Garrett Hardin created the economic term tragedy of the commons --.the failure of private incentives to provide adequate maintenance of public resources. The commons refers to any resource shared by a group of people. As the population grows, greed runs rampant and the commons collapses.

The tragedy of the commons is one of the most important topics in the human-earth relationship. Many resources – clean air, biodiversity, fresh water – are available to many people, and when resources are shared and limited (even if potentially renewable), those resources are often exploited. This is because the benefit to one person of using more of the resource outweighs the cost to that one person of the resource's overuse. Each person looks out for his own interests and succumbs to the logic that "If I don't use the resource, then someone else will. I might as well get the benefit."

The plight of the commons in Lloyd's day is similar to a number of contemporary examples of the tragedy of the commons: the depletion of fish stocks in international waters, industrial air pollution, congestion on urban highways and the rise of resistant diseases due to the careless use of antibiotics, just to name a few. The problem in all tragedy of the commons cases is directly related to the lack of clearly established property rights (a type of market failure). Learning to overcome our natural tendency to overuse common resources is one of the most significant challenges we face in working to improve our physical environment.

Dig DeeperYou might want to skim through the Garrett Hardin article, Tragedy of the Commons, in which the concept was first used.

If you're interested but Hardin's article is a little deep for you, try Ryan Somma's article, Tragedy of the Commons Explained with Smurfs.






Externalities occur when the production or consumption of one affects that of another.

Some externalities are negative such as mobile phone use in public places, reduced fishing yields from toxic waste dumping, loud music in residential neighborhoods and so on.

Some externalities are positive such as a neighbor who landscapes his property, soothing music in dentists’ offices, a regular exercise program and so on.

Because the economic decisions of one diminish the economic decisions of another, externalities are a type of market failure.






The problem of pollution is complex because it involves several kinds of market failures, resulting in disagreement over how to solve the problem. Two methods of dealing with pollution have been suggested by economists -- Pigouvian taxation and the Coase theorem.


Arthur PigouPigouvian Taxation

Arthur Pigou was a British economist who did most of his work in the early part of the 20th century. Pigou said the government should tax a polluting company for each unit of pollution it emits.

  • Companies have an incentive not to pollute.

  • Extra costs get passed on to the consumer.

  • Government uses the funds to fight pollution.

Pigou thought that the tax charged should attempt to equal the value of the damage caused. In order to be effective, though, the company would need to internalize the externality … it couldn’t just pass the tax to its customers and thus avoid the cost of its benefit.



                                When Is a Potato Chip Not Just a Potato Chip? (4:46)



Ronald CoaseThe Coase Theorem

Ronald Coase was an economist who won the Nobel Prize and wrote two very influential and controversial books in the last half of the 20th century (The Problem of Social Costs and The Firm, the Market and the Law). Coase wrote that private parties could bargain over the allocation of resources and could solve the problem of externalities on their own.

  • Disputes over resources arise because nobody owns them or because everybody owns them.

  • A private property system in which rights are clearly defined and in which the cost of exchange is negligible will achieve the optimal allocation and efficient use of resources.

In order for the Coase theorem to hold true, however, the cost of exchange or the transaction or negotiation costs must be low or negligible and the number of parties involved must be small. Coase suggested that in certain cases it might be more efficient for the victim to assume some or all of the costs of pollution.


                                                       WatchThe Coase Theorem: An Example

                                            Negative Externalities & the Coase Theorem (4:32)


The chart below can help you understand Coase’s ideas. It shows a hypothetical situation in which the waste from a factory’s production process threatens to pollute the water that supports a fishing industry.  Make sure you understand the chart and then look at the questions below it. You do not need to write out answers to those questions but you DO need to come up with answers so you’ll be able to complete the last part of your activity.



factory choices

factory profit

fishermen profit

total profit

no filter

no treatment





no treatment




no filter










1.    What if the factory is given the right to dump?

2.    Which alternative seems to be the most advantageous to the fisherman?

3.    How might a reasonable and equitable solution be achieved?

4.    Which of the alternatives seem to be the most equitable?

5.    What are the negative and positive externalities if property rights are assigned to the fishermen?

6.    What are the negative and positive externalities if property rights are assigned to the factory?

7.    What solutions apart, from Coase, could solve this problem?


Dig Deeper
The Coase and Pigouvian Theorems (PDF Presentation)




Copyright 1996 Amy S Glenn
Last updated:   09/13/2017   0130

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